2015-07-16

Stability Breeds Instability: Trading Limits Must Go

Setting a daily limit on share price changes in either direction was meant to prevent sharp market swings. The idea is that it will give investors more time to digest information before deciding whether or not to buy or sell a stock.

The reality of China's stock market, however, is the market seems to have fluctuated even more widely than bourses without the trading limit. For the cap to have the desired effect, investors must be willing to look for what made the price of a stock change, reasons that are related to the firm's condition and performance. This happens only in a market dominated by institutional investors who base their decisions largely on fundamentals.

If a company's stock is valued 50% lower by the market, the Chinese system requires more than six trading days to adjust. The reverse happens quicker, but it still requires several trading days. This enhances the Chinese retail investor's momentum instincts. Herd investors don't pile into a stock that undergoes a one-day adjustment, but they do start piling into (or fleeing from) shares that hit the trading limit for several days in a row. Market manipulation is also easier.